Cambridge Centre <strong>for</strong> <strong>Risk</strong> Studies Working Paper SeriesEquitiesUS EquitiesUK EquitiesEU EquitiesJapanese EquitiesAsia ex-Japan EquitiesUS Small Cap EquitiesEmerging Markets EquitiesBondsUS Government Bonds (ave 7 yr duration)UK Government Bonds (ave 7 yr duration)European Gov Bonds (ave 7 yr duration)Japan Gov Bonds (ave 7 yr duration)Corporate BondsHigh Yield BondsOther Exchange TradedProperty IndexPrivate EquityGold CommoditiesOther commoditiesCash LIBOR 1 MonthFor a specified stress test scenario in the framework, it is proposed that consequence analysisprovides outputs to enable insurance companies toa. estimate their underwriting losses across all <strong>of</strong> the relevant lines <strong>of</strong> business that might beimpactedb. evaluate how the scenario will cause operational impacts, and impair the macroeconomicenvironmentc. derive indicative estimates <strong>of</strong> how a scenario is likely to impact an investment portfolio.The scenarios are designed to provide holistic business stress tests <strong>for</strong> internal risk management ininsurance companies.8.2 Business operational risk managementThe taxonomy framework provides a checklist <strong>of</strong> threats that could cause disruption to internationalbusiness operations. Many businesses today maintain an ‘emerging risks’ committee or monitoringprocess. The systematic framework provided by the taxonomy provides a structure to monitoring theemerging risks <strong>of</strong> interest. The structure is useful if the scenarios can be used to simulate threats anddevelop disaster preparedness measures and contingency plans <strong>for</strong> business operations. Adapting thescenarios to ensure that they are useful <strong>for</strong> preparedness planning is an objective <strong>of</strong> the research.It would also be useful <strong>for</strong> businesses if the taxonomy framework provided indices <strong>of</strong> the current(and projected short term future trend) threat level <strong>for</strong> each and all <strong>of</strong> the threats, as early warningsystems to assist with preparedness. The possibility <strong>of</strong> developing indices is currently being explored.8.2.1 International Supply ChainsGlobal business systems are particularly encapsulated in international supply chains. The science <strong>of</strong>managing international business networks has rapidly evolved, trans<strong>for</strong>ming global supply chainsinto highly efficient backbones <strong>of</strong> modern business. But the drive <strong>for</strong> cost reduction has also reducedsafety margins and increased the potential <strong>for</strong> systemic failures from extreme events. Current bestpracticein supply chains recognizes how failures might occur, and develops efficient resiliency inoperations and system design to optimize protection <strong>for</strong> the business. Supply chain interruption hasbecome a major concern <strong>of</strong> global businesses, with disruptions causing serious impacts on acompany’s long run per<strong>for</strong>mance and equity risk. Top executives consider supply chain disruption tobe one <strong>of</strong> the greatest areas <strong>of</strong> concern in running their business. Managers are increasingly refiningtheir focus on efficiency to incorporate safety margins and incorporate measures to improve theresilience <strong>of</strong> supply chain operations – i.e. investing in just-enough safety margin to make aCambridge Centre <strong>for</strong> <strong>Risk</strong> Studies 1
Cambridge Centre <strong>for</strong> <strong>Risk</strong> Studies Working Paper Seriessignificant improvement on disruption, but not over-investing in wasteful measures. Analyzing andquantifying the value <strong>of</strong> resilience is an emerging area in the study <strong>of</strong> operations management.Shock scenarios from the taxonomy framework have been used to test the resilience <strong>of</strong> internationalsupply chains 33 , and are a particular application <strong>of</strong> the Cambridge <strong>Risk</strong> Framework 34 . Researchcontinues into modeling the impacts <strong>of</strong> scenarios in disrupting international supply chains, designingsupply chains with ‘efficient resiliency’, and quantifying contingent business interruption resultingfrom macro-catastrophe events.8.3 Government National SecurityA systematic risk framework also enhances ef<strong>for</strong>ts by national governments to provide contingencyplanning <strong>for</strong> future threats to national security, <strong>for</strong> energy, food and natural resources security, and<strong>for</strong> civil defense resource allocation 35 . Prioritizing resources <strong>for</strong> civil emergences requires a systematicassessment <strong>of</strong> the frequency, severity and characteristics <strong>of</strong> the threats faced, along the lines <strong>of</strong> thestructure proposed in the Cambridge <strong>Risk</strong> Framework. Scenarios developed in the framework wouldbe useful if they can provide estimates <strong>of</strong> casualties, civil disturbance, damage to essential lifelines,transportation systems, utilities, and other inputs into the assessment and planning <strong>of</strong> the resourcesneeded <strong>for</strong> public health, law and order, essential services, and humanitarian needs.8.4 Financial <strong>Risk</strong> <strong>Management</strong>The proposed taxonomy <strong>of</strong> threats is a rigorous catalogue <strong>of</strong> exogenous financial shocks, Theframework also incorporates the purely endogenous shocks <strong>of</strong> the financial system itself: Threatcategory #1. Financial Shock is allocated to the endogenous types <strong>of</strong> financial threats, such as assetbubbles, bank runs, sovereign defaults etc.Since the financial crisis <strong>of</strong> 2007-9, there has been considerable focus on understanding themechanisms, causes, and propagation <strong>of</strong> financial crises in order to improve risk management <strong>for</strong>future crises. Few areas <strong>of</strong> economic and financial risk management have been untouched by changesthat have been made in assessing asset and market risk, economic risk capital requirements,regulatory and supervisory changes, credit ratings, and acceptable levels <strong>of</strong> sovereign debt.Much <strong>of</strong> the focus <strong>of</strong> economic and financial research that has underpinned these changes has been oncredit withdrawal, liquidity evaporation, complexity economics, and the systemic risk to bankingnetworks from asset bubbles, bank runs, market crashes and other macroeconomic phenomena. Theseare commonly referred to as endogenous shocks, where the financial system experiences failures <strong>of</strong>internal mechanisms, in<strong>for</strong>mation asymmetry, or market inefficiency.A comprehensive view <strong>of</strong> macroeconomic risk also incorporates exogenous shocks – major events fromoutside the financial system, typical unexplained by economics alone, that can destabilise the systemor exacerbate a fragile economic environment. Historically, more financial crises appear to have beenthe result <strong>of</strong> endogenous processes than from pure exogenous shocks. The contribution <strong>of</strong> exogenousshocks appears minor but significant: a small number <strong>of</strong> crises have been directly triggered by geopoliticalevents and other major crises may have been exacerbated by external events.The threat taxonomy proposes a systematic structure <strong>for</strong> assessing all the likely causes <strong>of</strong> exogenousfinancial shocks to help investment risk managers estimate the statistical distributions <strong>of</strong> economic33A demonstration <strong>of</strong> the application <strong>of</strong> a System Shock scenario to an international supply chain is provided on the researchplat<strong>for</strong>m: http://cambridgeriskframework.com/page/2234Ralph et al., (2012) ‘Resilient International Supply Chains’, Centre <strong>for</strong> <strong>Risk</strong> Studies, University <strong>of</strong> Cambridge.35An example is the UK Government National <strong>Risk</strong> Assessment, cited earlier in this paper.Cambridge Centre <strong>for</strong> <strong>Risk</strong> Studies 17
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